Federal Reserve System Chapter 4 Federal Reserve System © 2011 John Wiley and Sons

Two Important Definitions CENTRAL BANK: Federal government agency that facilitates operation of the financial system and regulates money supply growth FEDERAL RESERVE SYSTEM (Fed): U.S. central bank that sets monetary policy and regulates banking system

Structure of the Federal Reserve System The Fed System consists of five components: Member Banks Federal Reserve District Banks Board of Governors Federal Open Market Committee Advisory Committees

Member Banks All national banks must be members of the Fed State-chartered banks are permitted to join the Fed system All member banks must purchase capital stock of the Reserve Bank of their district up to a maximum of 6% About one-third of commercial banks are members of the Fed Member banks hold about three-fourths of the deposits of all commercial banks

Member Banks and Other Depository Institutions Monetary Control Act of 1980: Increased the importance of the Fed in the nation’s financial system Generally eliminated distinctions between member banks of the Fed and other depository institutions (savings banks, S&Ls, & credit unions) Applies Fed-comparable reserve and reporting requirements to these other depository institutions

Two Recent Past Chairs of the Fed Board of Governors (continued) Alan Greenspan (Chair, 1987- 2006) Under his guidance, the U.S. generally benefited from an easy monetary policy, low inflation, real economic growth, relatively low interest rates, and relatively high stock prices

Ben Bernanke (Chair, 2006 – ???) Became Fed Chair in February, 2006, only a few months before the “housing price bubble burst” and the economy started slowing down. He was responsible for setting monetary policy that helped guide the U.S. through the 2007-09 financial crisis.

Monetary Policy Functions and Instruments: Overview Dynamic Actions: Fed actions that stimulate or repress the level of prices or economic activity Defensive Activities: Fed activities that offset unexpected monetary developments & contribute to the smooth functioning of the economy Accommodative Function: Fed efforts to meet credit needs of individuals & institutions, clearing checks, & supporting depository institutions

Monetary Policy and Instruments Monetary policy is formulated by the Fed to regulate money supply growth (as well as the cost and availability of money) Basic Policy Instruments: Changing Reserve Requirements Changing the Discount Rate Conducting Open-Market Operations

Monetary Policy Instruments Reserve Requirements: Fed sets reserve requirements for depository institutions Discount Rate Policy: Fed sets interest rate at which it will lend to depository institutions Open-Market Operations: Fed buys/sells government securities to change bank reserves

Reserve Requirements: Basic Concepts FRACTIONAL RESERVE SYSTEM: Reserves held with Fed that equal a certain percentage of bank deposits BANK RESERVES: Vault cash and deposits held at Federal Reserve Banks REQUIRED RESERVES: Minimum amount of total reserves a depository institution must hold

Reserve Requirements: Basic Concepts (Continued) REQUIRED RESERVES RATIO: Percentage of deposits that must be held as reserves EXCESS RESERVES: Amount of that total reserves are greater than required reserves

Discount Rate Policy DISCOUNT RATE: Interest rate that a bank must pay to borrow from its regional Federal Reserve Bank FORMS OF BORROWING: Borrowing institution may receive an “advance” (loan) or may “discount” (sell) to the Reserve Bank its “eligible paper”

Open-market Operations OPEN-MARKET OPERATIONS: Buying and selling of securities in the “open market” by the Fed to alter bank reserves FED’S ASSETS: Primarily held as U.S. government and government agency securities ORIGINAL FEDERAL RESERVE ACT: Did not provide for open-market operations

Implementation of Monetary Policy Monetary policy can focus either on: (1) Trying to control the rate of change or growth in the money supply (e.g., M1), or (2) Targeting a level for a specific type of interest rate (e.g., federal funds rate) Federal Funds Rate: Rate on overnight loans from banks with excess reserves to banks who have deficit reserves

Fed Supervisory Responsibilities On-site examination of commercial banks Function shared with: -Office of the Comptroller of the Currency (OCC) -Federal Deposit Insurance Corporation (FDIC) -state regulatory agencies

Supervision and Regulation of Non-Commercial Banks CREDIT UNIONS: Regulated by the National Credit Union Administration (NCUA) SAVINGS & LOANS AND OTHER SAVINGS INSTITUTIONS: Regulated by the Office of Thrift Supervision (OTS)

Fed Regulatory Responsibilities Consumer Credit Protection Act of 1968: Act requires clear explanation of consumer credit costs and prohibits overly high-priced credit transactions Regulation Z: Enacts Truth in Lending section of the Consumer Credit Protection Act with intent to make consumers able to compare costs of alternate forms of credit

Fed Service Functions The Payments Mechanism Necessary for the monetary system to carry out the financial function of transferring money. Involves: --Regulating amount of coin & currency --Check clearance and collection --Check routing Transfer of Credit Electronic Funds Transfers

Central Banks in Other Countries UNITED KINGDOM: Bank of England (BOE)--created well prior to the Fed JAPAN: Bank of Japan (BOJ)--created in 1947 EUROPEAN MONETARY UNION: European Central Bank (ECB)--created in 1999 Conducts monetary policy for the European countries that have adopted the euro as their common currency